Lecture Lecture 77

Making Financial Reporting Making Financial Reporting Decisions Decisions

Critique of Positive Accounting Critique of Positive Accounting TheoriesTheories

Making Financial Making Financial Reporting DecisionsReporting DecisionsModules 3, 4 & 5 deal with

theoretical frameworks related to making financial

reporting decisions

How do I make financial reporting

decisions?

Lecture OverviewLecture Overview Review of Modules 3 & 4

Positive Accounting Theory (PAT) Legitimacy Theory Stakeholder Theory

Module 5 Criticisms of positive accounting theories (5.1 -

5.3) Usefulness of theories and research results (5.4)

Intro to Modules 6 & 7 Two ways to evaluate the impacts of financial

reporting decisions

Review - positive Review - positive accounting theory (PAT)accounting theory (PAT)

Major focus is on stewardship role of accounting

Looks at reasons underlying financial reporting decisions

Emphasis on relationship between financial reporting decisions and contracts, particularly management compensation contracts and loan agreements (debt contracts)

Based on ‘agency theory’

Review - Agency Review - Agency TheoryTheory

Conflicts of interest give rise to agency costs

Contracts are used to reduce these conflicts of interest (bonding) - contract terms sometimes rely on accounting information

Firms prepare audited accounting reports to facilitate monitoring of these contracts (stewardship role of accounting)

Review - Implications Review - Implications for financial reporting for financial reporting decisionsdecisions

Because contracts are used to bond the agent to the principal, and financial statement information is often used to monitor the agent’s compliance with these contracts

Agents have incentives to present the financial statements in a way that ensures the best outcome under the contracts

Therefore, contracts need to be considered when making financial reporting decisions

Review – Legitimacy Review – Legitimacy TheoryTheory

Organisations seek to ensure they operate within the bounds and norms of their respective societies

relies upon the notion of a ‘social contract’ Represents the implicit and explicit

expectations that society has about how the organisation should conduct its operations

Review – Legitimacy Review – Legitimacy TheoryTheory

Legitimacy Theory proposes a relationship between corporate disclosure and community expectations

Consider implications of not meeting social contract when making financial reporting decisions may lead to sanctions such as legal

restrictions on operations, limited resources provided, or reduced demand for products

Review – Legitimacy Review – Legitimacy TheoryTheory

Disclosures form part of the portfolio of strategies undertaken to bring legitimacy to or maintain legitimacy of the organisation

Increase in environmental disclosures Over time Following social incidents or environmental

disasters Disclosures mostly positive

Review – Stakeholder Review – Stakeholder TheoryTheory

Definition of stakeholders is very broad Two branches of Stakeholder Theory:

ethical (moral) or normative branch Management ‘should’ be accountable to

all stakeholders positive (managerial) branch

Attempts to explain when corporate management will be likely to attend to the expectations of particular (powerful) stakeholders

Review – Stakeholder Review – Stakeholder TheoryTheory

positive (managerial) branch stakeholder power is a function of the

stakeholder’s degree of control over resources required by the organisation

Information, including financial accounting and social performance information, is a major element employed to manage stakeholders

Module 5Module 5

Critique of Positive Critique of Positive Accounting TheoriesAccounting Theories

(PAT, Legitimacy & (PAT, Legitimacy & Stakeholder)Stakeholder)

What is a critique?What is a critique?

A critical essay or analysis Critical thinking involves questioning

everything that you hear or read The critiquing of claims can alter our

ways of understanding the world Both strengths and weaknesses are

considered

Importance of critiquing Importance of critiquing in relation to studying in relation to studying this unitthis unit

All theories and related research have limitations Sometimes related to underlying

assumptions These should be understood and kept in

mind when using them to guide financial reporting decisions

More informed (better) decision making will be the result

Criticisms of PATCriticisms of PAT

Assumptions Underlying Assumptions Underlying PATPAT

Everything can be explained in terms of utility maximisation (self-interest) Promotes a ‘morally bankrupt view of the

world’ (Gray, Owen and Adams, 1996) Utility maximisation does not necessarily

relate to wealth maximisation (ignores some costs such as social costs)

However, wealth maximisation appears to be a reasonable assumption when explaining corporate decisions

‘‘Failure’ of PATFailure’ of PAT

Positive accounting theory does not provide prescriptions for how we should account

‘How to account’ is an important issue for practicing accountants and accounting regulators

However, we know that standard setting is a political /social process rather than a matter of deriving a set of ‘ideals’

And…

While Positive Accounting Theory While Positive Accounting Theory doesn’t tell us how we should doesn’t tell us how we should account, it does tell us what account, it does tell us what economic factors to consider when economic factors to consider when making financial reporting making financial reporting decisions.decisions.

Other Criticisms of PATOther Criticisms of PAT

Slow / limited development Not ‘value free’ Scientifically flawed – hypotheses

frequently not supported Results apply ‘on average’

Criticisms of Criticisms of Legitimacy and Legitimacy and Stakeholder Stakeholder TheoriesTheories Limited application to many financial

reporting decisions Eg. Expense vs. capitalise, accounting method

choices, disclosure vs. recognition Usefulness relates mainly to unaudited

disclosures Not ‘value free’ Pursuit of profits is the only ‘moral’

obligation of business (Den Uyl, 1984)

Criticisms of Criticisms of Legitimacy and Legitimacy and Stakeholder Stakeholder TheoriesTheories Legitimacy theory too broad, why is it

important to be legitimate? Empirical tests often involve counting

the number of pictures and words (lacks statistical rigour compared to PAT)

PAT remains as the dominant paradigm in relation to financial reporting

The usefulness of positive The usefulness of positive accounting theories and accounting theories and

research resultsresearch results

They are still useful!

In support of positive In support of positive accounting theoriesaccounting theories

Positive accounting theories provide some useful explanations and predictions for accounting and disclosure practice

Empirical support for the predicted hypotheses gives credibility to the theories

Growing body of evidence to support theories

Theories are simplifications of reality, and all suffer limitations

These theories are the best that we’ve got!

Using positive Using positive accounting theories in accounting theories in practicepractice

Before applying positive accounting theories in practice, you should be aware of their limitations

Remember, the theories are based on assumptions and these may not hold in reality

Also, before relying on particular research results, the validity of the results must be assessed (critique them)

Strengths of positive Strengths of positive accounting theoriesaccounting theories

Provide a useful framework for making financial reporting decisions

Helps to predict the effects of changes to accounting regulation Useful in relation to the future

development of accounting regulations Indicates the factors to consider when

making financial reporting decisions

Factors to consider when Factors to consider when making financial reporting making financial reporting decisionsdecisions

Contracts of the company Assets of the company Information asymmetries Potential political costs Society’s expectations of the company Power of various stakeholders Impact on share price Impact on individual financial statement

users

The usefulness of The usefulness of normative accounting normative accounting theoriestheories

Examples are the ethical branch of stakeholder theory and the Conceptual Framework

Provide an ‘ideal’ to work towards A starting point for standard setters

However we should not expect final accounting standards to fully reflect these ideals due to the process being political

Introduction to Modules 6 Introduction to Modules 6 & 7& 7

Impacts of Financial Reporting Decisions

The Impacts of Financial The Impacts of Financial Reporting DecisionsReporting Decisions

Modules 6 & 7 deal with research into the impacts of financial reporting decisions

How do my financial reporting

decisions impact on thedecisions of financial

statement users?

Financial Reporting Decisions

You arehere

Unregulated Financial Reporting Decisions

Regulated FinancialReportingDecisions

Making Financial Reporting Decisions

ContractingDeterminants of Financial Reporting

Social Determinants Of FinancialReporting

The Impact ofFinancialReportingDecisions

Critique of PAT

Share prices

Individuals

Impacts of Financial Impacts of Financial Reporting DecisionsReporting Decisions

There are two ways to assess the impacts of financial reporting decisions: Determine what impact the release of

information had on share price? (capital markets research)

Determine the impact of the information on the decisions of individual information users (behavioural research)

Comparison of Comparison of Behavioural and Capital Behavioural and Capital Markets ResearchMarkets Research Both examine the impact of financial reporting

decision on users of the info. Capital markets research assesses the aggregate

effect, while behavioural research assesses the effect on individuals

Capital markets research includes only investors, while behavioural research examines other types of financial statement users

Capital markets research assesses WHETHER the information is used, while behavioural research can asses HOW the information is used

For TutorialsFor Tutorials

Required reading Text chapter 7, pp. 235 – 239 Text chapter 10, pp. 358 - 359

Self assessment questions Questions 1 - 5 from module 5 Question 1 from module 6 Answers in tutorials